Brad Setser

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Very true — “The globalization of the credit crunch” has produced a series of currency crises in the emerging world

by Brad Setser
October 23, 2008

Alan Ruskin argues that the moves in the foreign exchange market today — with the dollar and yen rising sharply against nearly everything — reflect an unwinding of bets made on the assumption that the world economy would remain strong and market volatility would remain low even as the US slowed.

The dollar’s rise since July is part of a reversal in longstanding investment trends that prevailed during years of plentiful borrowing, strong growth and low financial-market volatility. “Essentially, every large trade that built up a head of steam in the go-go years has blown up or is in the process of blowing up,” wrote Alan Ruskin, chief international strategist at RBS Greenwich Capital, in a report to clients. “That goes for almost every asset class.”

That seems more or less right to me.

Crises have a way of clarifying what happened in the past. I think it is now clear that the scale of emerging market reserve growth from the end of 2006 to q2 2008 should have been a leading indicator that a lot of investors — probably too many — were betting that emerging markets (and indeed the world) could continue to grow rapidly even as the US slowed. Reserve growth was running well in excess of the emerging world’s current account surplus, as private capital was flowing into the emerging world in a big way. The IMF data indicates that private flows to the emerging world in 07 and the first part of 08 ($600b a year in 2007 — over twice the average pace of 04-06; see table A13 of the IMF’s WEO) were well above the levels seen before the 97-98 crisis.

Those capital flows — plus very low real interest rates, as many emerging markets followed the US rates down even though they were still booming — helped fuel surprisingly strong global growth even as the US slowed. The US actually wasn’t driving global demand growth over the last two years. Europe and a few booming emerging economies were. The world did decouple. Energy prices certainly decoupled from the trajectory of US demand. But only for a while.

In retrospect, large inflows to the emerging world – and expectations that emerging currencies were generally on an appreciating trend, making it safe to borrow in foreign currencies (or sell insurance against a large depreciation of an emerging market currency) led investors to take on a lot of risk. Consider for example the rise in borrowing from global banks by many emerging markets (documented by my colleagues at the Council’s Center for Geoeconomic Studies) over the past few years. The fuel for the current market fire was there.

I still never would have experienced that the emerging world could experience a sudden stop like it is experiencing now while it was still running a large aggregate current account surplus. Particularly after most emerging markets had built up rather substantial reserves. Both should have helped to buffer against a huge swing in market sentiment, at least in aggregate.

I haven’t done a detailed analysis, but my sense is that the scale and pace of recent market moves — and in all probability the scale and pace of associated capital flows — is comparable to the Asian crisis of 97-98.

Faster perhaps.

That is scary.

The leaders of the G-20 countries will have plenty to talk about when they meet in the middle of November.

UPDATE: I added Jim Reid’s line about the “globalization of the credit crunch” to the post’s title after posting it. I like the phrase. Reid is a credit strategist at Deutsche Bank.


  • Posted by Twofish

    To Chidambaram: The problem is that if you graph all of the numbers (number of foreclosures, number of delinquencies, housing prices etc. etc.), they are all trending the wrong way, and they haven’t hit bottom, and we still haven’t really had major job losses. Also, if you look at previous real estate bubbles it usually takes about three to five years from prices to hit bottom. House prices are very misleading because people will hold on to a house at an inflated price rather than sell it.

    The other problem is that no one knows right now who is going to get hit with the losses, so no one is lending money out of fear that the bank that they lent money to won’t be able to repay it.

    It is true that the ultimate cost to the government is not likely to be anywhere close to $700 billion, but you still need $700 billion in cash since you will likely have to issue cash for some sort of loan with collateral.

    I should point out that this is an example where some of the standard assumptions that you see in economics texts break down. In the abstract world of economics, $100,000 in cash is the same thing as $100,000 in T-bills is the same thing as $100,000 in gold is the same thing as a $100,000 house is the same thing as $100,000 in agency bonds.

    However in the real world, when someone wants $100,000 in cash, they want often want $100,000 in cash. Not T-bills, not gold, not stock, not bonds, not houses. Cash.

  • Posted by Twofish

    The other thing to note is how tiny more emerging markets are compared to the big banks. Thailand’s GDP using official exchange rates is about $250 billion. Citigroup has $2 trillion assets under management and about $100 billion in shareholder equity. What this means is that the capital flows between the big banks are just going to swamp your average medium sized country.

  • Posted by Judy Yeo


    caught roubini’s soundbite on closing the markets, wonder what you think of it (actually it was 3rd source info, having come from bloomberg via Yves Smith’s site).

    this will probably annoy some people but noentheless, guessing that the indian rupee might face significant pressure and that asia might find itself not so buffered after all. funds ( those who are still existing) might well find bargains in the region though, but convincing investors to cough up the money in such times might well be tough.

    am looking at June 09 as time when the crisis and the recession undeniably lands in asia; as in main street will see full blown effect; any other guesstimates?

  • Posted by RBG


    You said:

    Currency swaps among central banks for example would allow everyone to hold more reserves w/o requiring trade surpluses to build up reserves. I am very worried that Korea will defend a weak won as it builds up reserves — and that this will be a major constraint on China’s willingness to allow further RMB appreciation (at least v the USD).

    1) Shouldn’t Korea burn its reserves to defend weak Won? How does it do that while building reserves?
    – Also, I don’t see how Korea will build its reserves. Korea is very export dependent and esp to shipbuilding, steel and auto sector. So, despite the weak Won, the global demand situation is unlikely to help its export for the coming 2-4years.

    2) I always thought that it was the worry of its price competitiveness in export that is blocking China from further RMB appreciation. However, it seems that you have some other pressure in your mind. Can you please give me some more clarification?

    Thank you.

    Always appreciate your posts.

  • Posted by RBG

    I apologize all writing turned italian… Apparently I do not really know how to use html tags…

  • Posted by satish

    Imf cannot rescue the currency crisis to the full extent because they dont enough resources to rescue
    eastern Europe, central america, south asia and other host of individual countries because imf has only 200bn but the rescue requires atleast 300bn dollars for the rescue. Apart from that imf gets the money from US, EUROPE and JAPAN who themselves are in trouble. They would better use the resources for their use.
    US economy cannot recover this crisis easily because US is a credit based economy. Since US is a speculative economy there are no real productive assets . Credit is given based on asset prices and their rise and not on wages people receive.Thus falling asset prices and stocks lead to lesser credit and lesser credit leads to lower assets prices which becomes a vicious circle. Economy will bottom out only when economy gets out of cluctches of credit .

    Srinath- India is particularly vulnerable because india’s forex reserves basically consists of 100bn of NRI deposits , 75bn of external commercial borrowings and 50 bn of f ii which covers the bulk of forex reserves. ECB are to paid back over 5yers average and thus India is vulnerable to 200-250bn $
    capital flight as rest of them are hot money inflows.

    Pakistan will get imf financing this time but they will blow up within one year since Pakistan runs a current deficits of 15bn dollars each year and world cannot give free financing to Pakistan each time. They will go bankrupt next year and a next dictator will invade strait of Hormuz and will choke the world of oil and put world economy into a hyper inflationary depression.

  • Posted by RebelEconomist


    You are not missing anything; all the parts are there. As you say, the US cannot use CA deficit funding to finance reserves accumulation. I am turning this argument around to say that, if the US had acquired more reserves, it would have had less of a CA deficit. In other words, the US CA deficit is at least as much due to the US itself as China.

    How would this have worked? The funding could have either come from higher taxation – ie a smaller government deficit – or extra government borrowing (hopefully offset by lower consumption via higher long term interest rates). Either of these would have lowered US consumption, including imports. None of the changes implied should have been unacceptable – it would be hard to argue that (1) US reserves were too high (2) the US government deficit was too low (3) US long term interest rates were too high (4) US consumption was too low.

    Essentially, the option of funding reserves accumulation by selling extra debt boils down to a reserves swap. The extra demand for US debt from foreign reserves managers is accommodated, and the proceeds are used by the US to buy foreign currency debt. Just as if the US swapped saleable dollar assets for saleable foreign assets. Of course, at a more detailed level, since the renminbi is not convertible, the US would have had to buy euros, yen and pounds etc, but this would have spread the load of Chinese “mercantilism” to other countries.

    By the way, most of these points apply to the UK too.

  • Posted by Italian reader

    Just two cents from an amateur economist like I am : my impression is that we are in a typical phase 2 of a crisis that breaks up in the centre of the financial system (US)

    The phase 1 is a slowing of the US, with the rest of the world still not affected: in that phase the dollar is devalued and there is a general impression of the so called “decoupling”. This mood is evident, for example, in “Not America’s decline – the rise of everyone else”

    In phase 2 the rest of the world starts the slowdown and the financial stress in US increase: at this point the US financial institution bring back in the US the capital invested abroad to support the US markets. Basically as today all the decision made by US policymakers are try to save the banks and inject as many liquidity as possible in the financial system, seen as the core of the problem, while the “real” economy (business and family) is not considered critical yet.
    The impression in phase 2 is the overdependence of the whole world to US.

    Normally the phase 3 is the recovery of the US economy, the stabilization of the US dollar and of the rest of the world economy.

    But this time I think that imbalances have grown so far that will be impossible to postpone any adjustment in US by adding more debt (public this time).
    We will enter in phase 4: when Dow Jones will break 7200-7600 level and go down to 5000 or so any effort to save the US financial system will be useless and counterproductive, and the shift will be save the US real economy instead of US financial system. At that point dollar will be greatly devalued against all currencies, and particularly those who supports US system (China, Japan, etc.) to prop-up US exports, and BWII will finally collapse.

    Until then the imbalances won’t be corrected much (trade deficit of US will go down overall in Q4 but not with China, instead this deficit will pass from currently 42% to 66+% of total, in my opinion)..

  • Posted by a

    “Why not term out the debt? ”

    I agree. The yield on 30-years is now close to 3.8%. If the US Gov had any sense, it would start selling these suckers big time. The rest of the world wants Treasuries? I say, give them Treasuries.

  • Posted by JKH



    Your implied objective seems to be to fund US reserve accumulation while maintaining the level of total USG debt financing. You would then aim to offset new debt financing required for reserve accumulation (investment) with a reduction in debt financing required due to a reduction in the budget deficit (net expenditures). Total debt financing (defined to include the currency swap alternative) would remain unchanged.

    A reduction in the budget deficit would reduce the existing current account deficit, other things equal. A reserve increase would have no further effect on the budget deficit or the current account deficit, other things equal. An international dollar debt issue or a currency swap would increase gross but not net US international liabilities. A domestic debt issue followed by market intervention to build reserves similarly would affect the gross but not the net international balance sheet.

    As I said, I find the interpretation of this to be quite analogous to the debt/deficit effect of the TARP, which has been totally confused in Treasury’s communication and the general understanding of the budgetary fiscal effect. Paulson said in a Charlie Rose interview a couple of days ago that his biggest mistake/shortcoming in communicating the program was this aspect.

  • Posted by DJC

    East Asia to establish 80-bln-dlr fund to cope with the financial crisis

    China, Japan and 11 other Asian nations agreed Friday on an 80-billion-dollar war chest to save beleaguered currencies in the most ambitious regional plan yet to cope with the financial crisis.
    “We plan with our East Asia dialogue partners to launch (the fund) as soon as possible,” said Sultan Hassanal Bolkiah of Brunei, one of the 13 nations planning to take part in the fund.

    Earlier in the day, Chinese and Japanese leaders reached consensus on the plan with their counterparts from South Korea and the 10 members of the Association of Southeast Asian Nations (ASEAN).

  • Posted by ttnk

    To summarize this particular (detachment’s phase in progress) “fractal dimension”;
    1. SDRs aren’t that special anymore;
    2. Thank you doves for understanding and
    3. Thanks, fairies, for the ride. For now.

    Guess who’s going to be importing a lot? How’s that for “architecture”?

  • Posted by Chidambaram

    I agree with you that ‘there’s little chance of X’ is not a ‘good enough’ investment strategy.
    The total ‘brick and mortar’ loss, coming from a bank’s loss due to a foreclosed home, can’t possibly be more than around $ 200 b so far. Treasury is already sitting on a $700 b bailout.
    The reason financial institutions are suffering much bigger losses is because the notional principal on a credit default swap (CDS) is not tied to that on the underlying loan, or ‘referenced liability’.
    The ‘credit crisis’ is a result of FIs not having adequate capital to meet their CDS settlement related obligations, which are mostly obligations amongst themselves.
    This ‘notional crisis’ is already thawing, and soon markets will be back to normal.
    I believe in simple examples which can make points very clear, so let’s embark on one.
    Bank A lends $300,000/= to ‘Risky Borrower’ B on a house.
    Then Bank A goes and buys protection for $300,000/= from Hedge Fund F by going long in a CDS.
    Hedge Fund F then trades the CDS out to Investment Bank I. I trades it out to Bank C, and so on and so forth.
    Many people get to know about this transaction and many new CDS contracts come into the market, referencing the same loan, and get traded around.
    Soon what you have is a situation where the loan principal o/s is the same $300,000 whereas the notional principal o/s on CDS contracts related to the same loan is closer to around, say, $5 million.
    Borrower B defaults, and the original Bank A recovers 20% less than the loan, so that Bank A’s loss is $60,000.
    But because other institutions are short in CDS contracts on the same loan, the losses to them will be 20% of $ 5 million, which is $1 m.
    They can’t honor this obligation because they never had capital adequacy to go short in the CDS to begin with.
    In the melee, everyone starts mistrusting everyone else, among the FIs, and stops normal lending to one another to see how this situation gets sorted out. They also tighten their norms in lending to customers.
    The amplification of ‘brick and mortar’ losses of only $60,000 through CDS o/s in this example throws the financial system into losses of $1,000,000.
    But we have to remember that the $60,000 in brick and mortar losses is now sitting in the pockets of real world traders of goods and services;
    whereas the $1,000,000 CDS loss is also an immediate CDS gain for another financial institution.
    The total o/s CDS principal is more than $40 trillion. It’s difficult to estimate the loss to FIs from CDS settlements, but however large this is, it’s going to reflect immediately as a gain in another FI’s books.
    Going forward:
    OFHEO data shows that the monthly percentage decrease in home prices is already decreasing.

  • Posted by LB

    satish: “…because imf has only 200bn but the rescue requires atleast 300bn dollars for the rescue.”

    since moldbug’s not here, thought i’d throw this out.

    is the only way to fund the IMF at this point is through selling their a chunk of their gold reserves?

    would china be a likely and/or willing buyer?

  • Posted by LB

    2fish — anyway to know the amount of new CDS contracts on various underlying instruments initiated in the last month?

    if not, harbor a guess?

    do you think there has been any CDS market in Agencies and/or Treasuries?

  • Posted by RebelEconomist


    I believe you are correct, but that is not how I think about it. The objective of my schemes is for the US government to accommodate foreign countries’ use of the dollar in the way that is most advantageous for the US, rather than to accumulate US reserves per se. In China’s case, their declared objective is also not to accumulate reserves, it is to maintain a currency peg. Both of my suggestions (tax or extra debt sales) work partly by directly reducing import demand and hence the trade deficit with China (and thereby reduce their reserves accumulation), and partly by spending the extra government revenue on convertible foreign currency (and subsequently on foreign assets) to give the US a trade surplus (or at least a smaller deficit) with those countries. If China’s real objective was to accumulate a certain amount of reserves or maintain a trade surplus of a certain value, they would presumably respond by targeting a weaker renminbi/dollar exchange rate, and the US in turn would need to buy more non-renminbi reserves to accommodate them.

    Anyway, I hope you agree that both schemes would work (economically if not politically).

    In passing, note that another option which I did not mention on this occasion is that the US could import more durable goods from overseas (eg German trains) rather than financial assets, in which case its current account deficit would not fall as much, but it would have more domestic assets to produce resources to service its debt held by foreign central banks.

    I think the TARP is easier to understand, because in that case it is not necessary to consider different currencies and countries. Here I think the source of confusion is that, as TARP has been regarded as a bailout, it is assumed that the assets are practically worthless so that the headline figure will indeed end up as expenditure rather than investment.

  • Posted by Soxfan

    I’m in FX sales at a top 5 fx bank, and I cover a number of institutional clients who are heavily involved in emerging markets. On the whole, the investment community has not sold a FRACTION of its holding of EM paper. That process is in its infancy.

    To date, the carnage in EMFX is largely the result of the global liquidity squeeze, as the world’s ability to fund Dollar assets and service Dollar debts has gone to zero.

    Note what happened in Brazil yesterday. USDBRL opened limit up on the local futures, trading around 2.52. The Brazilian central bank then announced the initiation of a $50bn (25% of their outstanding reserves) program of providing fx swaps to locals. The mechanism is a simple fx swa,p whereby the BCB will sell USD for spot settlement to locals, buying BRL, and simultaneously buy back those dollars for settlement at some future date. Nobody’s actual FX exposure has changed in this trade, but the locals have use of the Dollars for the term of the swap. USDBRL fell over 10% from the highs on the news, which to me is pretty good evidence these moves are not about FX exposure at all, but are instead rooted in teh global dearth of Dollar liquidity.

  • Posted by Judy Yeo

    ttnk and Gregor Neumann

    as far as emerging economies go, the bets (and earliest profits) are always on “potential”- what is already fully developed isn’t potential anymore, it’s part of profits reported which ultimately attract the later investors/bettors. Iguess the easiest way to see this is the very “industry” of venture capitalism – if it works out, it’s profitable. if it doesn’t work out, it’s a loss.

    mind you, not saying that India doesn’t have problems; it has a huge array of problems, not least social, economic and political . Then again, so does China, to different extents of course. the question is can India emerge stronger from this crisis the way China had from 97/98. Will they take the opportunity to create a miracle?

    nice invective against foreign loans and capital but does it ever work ? how much organic growth has there really been in China? The biggest question re: Korea is why? particularly after its horrendous experience in 97/98?

    BTW, that korea and india comment and question in earlier posts werev made before the collapse yesterday, maybe that answered questions and vindicated answers – I’m still as dumb as ever unfortunately and not afraid to admit my dumbness!

  • Posted by df

    It s hard for me to be surprised when everything is happening as it has in the past and as it should.
    All this was expected, it may be happening a bit faster then expected, but hey … We ve been waiting so long for imbalances to be fixed for market to come back to reality … It s no surprise adjustment goes faster when it has been delayed for so long.

  • Posted by JSharap


    There is a rumor that China is planning to devalue the Yuan by as much as 30% within days!